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FINANCE

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Finance Definition

The management of money

 

What is Finance?

Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting. There are three main types of finance: (1) personal, (2) corporate, and (3) public/government. This guide will unpack the question: what is finance?

 

 

Examples

The easiest way to define finance is by providing examples of the activities it includes. There are many different career paths and jobs that perform a wide range of finance activities. Below is a list of the most common examples:

 

·       Investing personal money in stocks, bonds, or guaranteed investment certificates (GICs)

·       Borrowing money from institutional investors by issuing bonds on behalf of a public company

·       Lending money to people by providing them a mortgage to buy a house with

·       Using Excel spreadsheets to build a budget and financial model for a corporation

·       Saving personal money in a high-interest savings account

·       Developing a forecast for government spending and revenue collection

 

Finance Topics

There is a wide range of topics that people in the financial industry are concerned with. Below is a list of some of the most common topics you should expect to encounter in the industry.

 

·       Interest rates and spreads

·       Yield (coupon payments, dividends)

·       Financial statements (balance sheet, income statement, cash flow statement)

·       Cash flow (free cash flow, other types of cash flow)

·       Profit (net income)

·       Cost of capital (WACC)

·       Rates of return (IRR, ROI, ROA)

·       Dividends and return of capital

·       Shareholders

·       Creating value

·       Risk and return

·       Behavioral finance

 

Finance Careers

A definition of finance would not be complete without exploring the career options associated with the industry. Below are some of the most popular career paths:

 

·       Commercial banking

·       Personal banking (or private banking)

·       Investment banking

·       Wealth management

·       Corporate finance

·       Mortgages / lending

·       Accounting

·       Financial planning

·       Treasury

·       Audit

·       Equity research

·       Insurance

 

There are several branches within finance:

 

Personal Finance:

Deals with individual financial decisions like budgeting, saving, investing, retirement planning, and managing debts.

Personal finance is defined as "the mindful planning of monetary spending and saving, while also considering the possibility of future risk". Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, investing, and saving for retirement. Personal finance may also involve paying for a loan or other debt obligations. The main areas of personal finance are considered to be income, spending, saving, investing, and protection. The following steps, as outlined by the Financial Planning Standards Board,suggest that an individual will understand a potentially secure personal finance plan after:

·       Purchasing insurance to ensure protection against unforeseen personal events;

·       Understanding the effects of tax policies, subsidies, or penalties on the management of personal finances;

·       Understanding the effects of credit on individual financial standing;

·       Developing a savings plan or financing for large purchases (auto, education, home);

·       Planning a secure financial future in an environment of economic instability;

·       Pursuing a checking or a savings account;

·       Preparing for retirement or other long term expenses.

 

Corporate Finance:

Involves managing financial activities within a corporation, such as capital budgeting, investment decisions, and analyzing ways to maximize shareholder value.

Corporate finance deals with the actions that managers take to increase the value of the firm to the shareholders, the sources of funding and the capital structure of corporations, and the tools and analysis used to allocate financial resources. While corporate finance is in principle different from managerial finance, which studies the financial management of all firms rather than corporations alone, the concepts are applicable to the financial problems of all firms,and this area is then often referred to as "business finance".

 

Typically, then, "corporate finance" relates to the long term objective of maximizing the value of the entity's assets, its stock, and its return to shareholders, while also balancing risk and profitability. This entails  three primary areas:

·       Capital budgeting: selecting which projects to invest in – here, accurately determining value is crucial, as judgements about asset values can be "make or break"

·       Dividend policy: the use of "excess" funds – are these to be reinvested in the business or returned to shareholders

·       Capital structure: deciding on the mix of funding to be used – here attempting to find the optimal capital mix re debt-commitments vs cost of capital

·        

                                                   The latter creates the link with investment banking and securities trading, as above, in that the capital raised will generically comprise debt, i.e. corporate bonds, and equity, often listed shares. Re risk management within corporates, see below.

 

Financial managers – i.e. as distinct from corporate financiers – focus more on the short term elements of profitability, cash flow, and "working capital management" (inventory, credit and debtors), ensuring that the firm can safely and profitably carry out its financial and operational objectives; i.e. that it:

 (1)  can service both maturing short-term debt repayments, and scheduled long-term debt payments,

 (2) has sufficient cash flow for ongoing and upcoming operational expenses. See Financial management and Financial planning and analysis

 

Public Finance:

Focuses on government-related financial activities, including taxation, budgeting, and spending by governments at various levels (local, state, federal).

Public finance describes finance as related to sovereign states, sub-national entities, and related public entities or agencies. It generally encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods typically encompass five or more years. Public finance is primarily concerned with: 

 

 

·       Identification of required expenditures of a public sector entity;

·       Source(s) of that entity's revenue;

·       The budgeting process;

·       Sovereign debt issuance, or municipal bonds for public works projects.

 

                                          Central banks, such as the Federal Reserve System banks in the United States and the Bank of England in the United Kingdom, are strong players in public finance. They act as lenders of last resort as well as strong influences on monetary and credit conditions in the economy.

 

Development finance, which is related, concerns investment in economic development projects provided by a (quasi) governmental institution on a non-commercial basis; these projects would otherwise not be able to get financing. See Public utility § Finance. A public–private partnership is primarily used for infrastructure projects: a private sector corporate provides the financing up-front, and then draws profits from taxpayers or users.

 

 

Investment Banking:

Involves helping companies raise capital through issuing stocks or bonds, providing advisory services for mergers and acquisitions, and other financial transactions.

Investment management  is the professional asset management of various securities – typically shares and bonds, but also other assets, such as real estate, commodities and alternative investments – in order to meet specified investment goals for the benefit of investors.

 

As above, investors may be institutions, such as insurance companies, pension funds, corporations, charities, educational establishments, or private investors, either directly via investment contracts or, more commonly, via collective investment schemes like mutual funds, exchange-traded funds, or REITs.

 

At the heart of investment management is asset allocation – diversifying the exposure among these asset classes, and among individual securities within each asset class – as appropriate to the client's investment policy, in turn, a function of risk profile, investment goals, and investment horizon (see Investor profile). Here:

 

·       Portfolio optimization is the process of selecting the best portfolio given the client's objectives and constraints.

·       Fundamental analysis is the approach typically applied in valuing and evaluating the individual securities.

·       Technical analysis is about forecasting future asset prices with past data

                                                   Overlaid is the portfolio manager's investment style – broadly, active vs passive, value vs growth, and small cap vs. large cap – and investment strategy.

 

In a well-diversified portfolio, achieved investment performance will, in general, largely be a function of the asset mix selected, while the individual securities are less impactful. The specific approach or philosophy will also be significant, depending on the extent to which it is complementary with the market cycle.

 

A quantitative fund is managed using computer-based mathematical techniques (increasingly, machine learning) instead of human judgment. The actual trading also, is typically automated via sophisticated algorithms.

 

Risk management

Risk management in finance is the process of identifying, assessing, and mitigating potential risks that could negatively impact financial objectives. It's a critical aspect of financial decision-making and involves several key steps:

 

1. 1.       Risk Identification: This involves identifying and understanding the various types of risks a financial entity might face. Common risks include market risk, credit risk, operational risk, liquidity risk, and more.

 

1. 2.       Risk Assessment: Once risks are identified, they need to be assessed in terms of their potential impact and likelihood of occurrence. This step involves quantifying and qualifying risks to prioritize them based on their significance.

 

1. 3.       Risk Mitigation: After assessing risks, strategies are developed to mitigate or manage them. This might involve diversification of investments, hedging strategies, setting up risk reserves, implementing internal controls, or purchasing insurance.

 

1. 4.       Monitoring and Review: Risk management is an ongoing process. Regular monitoring of risks and the effectiveness of mitigation strategies is essential. It allows for adjustments and improvements in risk management approaches as circumstances change.

 

1. 5.       Regulatory Compliance: Financial institutions often operate within regulatory frameworks that prescribe specific risk management practices. Compliance with these regulations is crucial.

 

1. 6.       Risk Culture and Communication: Encouraging a risk-aware culture within an organization is important. Effective communication of risks and their implications to all stakeholders helps in better decision-making.

Each type of risk requires specific tools and methodologies for assessment and management. For instance:

 

·       Market Risk: Associated with fluctuations in financial markets. It includes interest rate risk, currency risk, and commodity price risk. Techniques like Value at Risk (VaR) are used to measure and manage market risk.

 

·       Credit Risk: Arises from the potential that a borrower or counterparty will fail to meet their financial obligations. Credit risk assessment involves credit ratings, credit scoring, and analyzing creditworthiness.

 

·       Operational Risk: Pertains to risks from internal processes, systems, or people. It includes fraud risks, IT failures, and human errors. Risk mapping and internal controls help manage operational risks.

 

Implementing effective risk management practices is crucial in maintaining financial stability, reducing losses, and ensuring the long-term success of financial institutions and businesses.

 

Financial Markets: Encompasses trading securities  like stocks, bonds, commodities, and derivatives in stock exchanges or over-the-counter markets.

 

Quantitative finance

Quantitative finance is a field that applies mathematical and statistical methods to financial markets and problems. It involves using mathematical models, computational tools, and algorithms to understand, analyze, and make decisions in finance.

 

Key components of quantitative finance include:

 

1. 1.       Financial Modeling: Quantitative analysts, often called "quants," use mathematical models to value financial instruments, price derivatives, and forecast market behaviors. These models can range from simple statistical models to complex stochastic calculus-based models.

 

1. 2.       Risk Management: Quantitative methods are extensively used in risk management to measure and mitigate various types of risks faced by financial institutions, such as market risk, credit risk, and operational risk.

 

1. 3.       Algorithmic Trading: Quantitative finance plays a significant role in the development of algorithmic trading strategies. These strategies involve using mathematical models and algorithms to execute trades automatically based on predefined criteria.

 

1. 4.       Derivatives Pricing: Quantitative techniques, like the Black-Scholes model, are used to price options and other derivatives. These models help in determining fair values for these financial instruments.

 

1. 5.       Portfolio Optimization: Mathematical methods are employed to construct and optimize investment portfolios by considering risk tolerance, return expectations, and diversification.

 

1. 6.       High-Frequency Trading: Involves using quantitative models and algorithms to execute trades at very high speeds, often relying on computational power and sophisticated algorithms to exploit market inefficiencies.

 

 

Professionals in quantitative finance typically have strong backgrounds in mathematics, statistics, computer science, and finance. They develop and apply mathematical models to analyze financial markets, design trading strategies, and manage risks. Quantitative finance has significantly evolved with advancements in technology, allowing for more sophisticated models and faster computations, thereby influencing various aspects of financial decision-making.

 

 

Financial Management:

 

 Involves planning, directing, and controlling financial activities within an organization, including financial analysis, forecasting, and risk management. 

 

Understanding finance is crucial in making informed decisions about money, whether it's managing personal finances, running a business, or making investment choices. It involves analyzing risks, forecasting financial trends, and making strategic decisions to achieve financial goals.

 

·       Financial management in finance refers to the strategic planning, organizing, directing, and controlling of financial resources within an organization to achieve its objectives effectively. It involves making decisions about how funds should be acquired and allocated and how assets should be utilized to maximize value for shareholders or stakeholders.

·

Key aspects of financial management include:

1. Capital Budgeting: This involves determining which long-term investments and projects a company should undertake. It includes evaluating potential investments based on factors like expected returns, risks, and strategic fit.

2. Financial Planning and Analysis: Creating detailed financial plans, forecasts, and budgets to guide the organization's future financial activities. This process involves analyzing historical data, market trends, and making projections.

3. Risk Management: Identifying potential risks to the organization's finances and developing strategies to mitigate or manage those risks. This includes market risks, credit risks, operational risks, etc.

4. Capital Structure Management: Deciding on the mix of equity and debt that the company should use to finance its operations and investments. This decision affects the cost of capital and risk for the company.

5. Working Capital Management: Managing short-term assets and liabilities to ensure the company has enough liquidity to meet its short-term obligations while maximizing operational efficiency.

6. Dividend Policy: Determining how much of the company's profits should be distributed to shareholders as dividends versus retained for reinvestment in the business.

                                                                    Financial managers use various tools and techniques to make informed decisions, including financial analysis, ratio analysis, cash flow analysis, and scenario planning. They play a crucial role in ensuring the financial health and stability of an organization by optimizing its resources and making strategic financial decisions aligned with the company's goals and objectives.